Bankruptcies happen in the markets, it’s a fact of capitalism. In the futures industry, there’s been a long and winding road to ruin by the likes of Volume Investors, Stotler, Griffin Trading, Drexel, Refco, Sentinel and Lehman Brothers. Although each of those events had glitches, nothing seemed to match the short- and long-term destruction of the MF Global, and to a smaller extent, PFG, bankruptcies. These bankruptcies, to paraphrase Tolstoy, were unhappy in different ways.
Having clients who were affected by these debacles, and hearing the frustration from the industry, Diane Mix Birnberg, founder and chairman of Horizon Cash Management in Chicago, decided to get a better measurement of the impact on the managed funds industry. Using the list of NFA-registered commodity trading advisors (CTA) and commodity pool operators (CPO), Horizon sent a survey asking 35 questions from how specifically these firms were impacted to what recommended solutions did they want to see put in place going forward. The findings were interesting.
“We didn’t see that anyone had spent time listening to this group,” Birnberg says. “So we asked these traders, if and how they were involved, to what extent they were hurt and how they were still affected.”
Although distributed globally, 85% of the responses were from U.S.-based CTAs and CPOs, which gave the survey about a 15% response rate.
63% of the respondents had been in business less than 10 years while 37% had been in business more than 10 years.
Most responding CTAs and pool operators were “newer” to the industry. Assets under management bolstered this, with 54% of respondents managing under $5 million, 30% between $5 million and $100 million, and 16% managing from $100 million to $5 billion. Birnberg wasn’t surprised by this skewed response because younger CTAs typically are the ones who don’t have a voice and saw this as a way to speak out, she says.
Only 5% of respondents had their positions and margin funds transferred to another FCM within two days after the FCM failure. The majority said the time frame was a week or longer. Some 22% had positions closed out without notification.
Interestingly, and sadly, 73% of the respondents had been involved in one or more of the futures commision merchant (FCM) failures named in the Horizon survey, but Birnberg says they found there were major differences between the impact of MF Global and PFG and the other failures, such as Refco or Stotler. “The first difference we found is, it really took a while to get positions moved — that really hadn’t happened before, and this time it happened to a lot of (CTAs and CPOs),” she says.
Futures interviewed regulators on this problem after the MF Global collapse as well as after the PFG failure. The response has been that in both the MF Global and PFG cases, segregated funds were missing. In other failures, for the most part, the segregated funds were whole and were able to be transferred to other viable FCMs according to the rules.
The second difference was the lack of information and guidance from all fronts: The FCMs, the Commodity Futures Trading Commission (CFTC), the futures exchanges and the National Futures Association (NFA), which led to a lot of “frustration and anger,” Birnberg says. “There was this black hole at the start in which no one knew what was going on. No one let [traders] know if positions were moved or not…traders had no idea where they stood.” She believes the lack of communication problem still exists today. Respondents stated the industry hurt itself in the process: 81% stated they didn’t think there had been an industry-wide effort to educate the press and public on what was being done to restore trust and integrity to the futures markets. Another 77% said their FCMs hadn’t offered any ideas or products to help strengthen the protection of customer funds.
60% of respondents had never done a periodic risk assessment to determine the impact of FCM failure, but almost as many perform due diligence on their FCMs yearly.
What surprised Birnberg most was the laxity by CTAs/CPOs in protecting themselves — and their segregated funds — even after the MF Global and PFG failures. Just over 50% responded they used between one to three FCMs and many said they still hadn’t done periodic risk assessment of their FCMs.
“While it’s understandable they can be angry about what happened, there is a need for CTAs/CPOs to take ownership,” Birnberg says, adding that spreading the risk around multiple FCMs is perhaps one of the easiest ways to protect themselves. She also notes that 57% said they had no practical way to verify their customer segregated funds amount at FCMs, something that may have changed now with the NFA’s new setup to electronically obtain daily segregation balances from all depositories (see “Double check“). Most responded they currently use broker statements as a check, which really doesn’t provide the needed information, Birnberg says.
This belief is a fact confirmed by the Berkeley Research Group report the NFA commissioned to review its procedures (go to http://www.nfa.futures.org/news/BRG-report.html to see a copy of the findings). The NFA stated it would put in place all the recommendations, including enhanced auditor training, and other safeguards, like confirming audit details with the firm’s outside auditor.
Respondents also supported certain industry remedies such as creating an insurance fund, establishing a separate custodial entity to hold customer funds and ensure real-time verification of balances for customers by regulators, strengthening current regulation to prohibit FCMs from using customer segregated funds or suffer severe consequences, and creating regulation and procedures to guarantee that all positions and margin are transferred immediately when bankruptcy is declared.
Birnberg also believes there needs to be guidance for CTAs, especially those that are relatively new to the business.
“These guys love to trade, but it is a business,” she says. “They need to be checking counterparty risk regularly and perform due diligence on their FCMs more than periodically. Only 59% of respondents said they did that, meaning the rest didn’t do any review.”