I know, I know, segregated funds are not very interesting. They're certainly not fun to read about and even less fun to write about. However . . . they are an extremely important issue for the futures industry after the events of MF Global, Sentinel Capital Management, and Peregrine Financial Group (PFG Best). The repeated misuse of customer seg funds has caused a crisis in the futures industry, and what's even worse, there's no clear solution in sight.
Consider this: The number of FCMs (Futures Commission Merchants) has fallen by 33% over the past five years due to consolidation and closure, and by 2014 that number is expected to decline by another 20%.*
There are really two problems affecting the futures industry. First, lower interest income from investing client seg funds, which is historically a major component of a futures broker's profitability, due to the Fed's 0% interest rate policy. Luckily, this issue will eventually correct itself when the Fed begins raising short-term rates. It's a temporary problem, even though it's gone on now for almost five years.
That brings us to the second problem, which is the handling of seg funds. It's the real problem for the futures industry which must be solved because there is genuine fear among clients as to whether their funds are safe at futures brokers. What's more, not only have customer seg funds been misused, but the court system has not functioned properly to return the funds promptly.
The question for the futures industry now is whether to rely on regulators to fix the problem or should the industry develop its own solution?
What are seg funds?
Seg funds stand for "segregated funds," which are monies held by a futures broker and are technically a customer’s private property. The accounts are required to be segregated – thus the name – from the firm’s own funds and are kept in a completely separate account at a clearing bank. The segregation of customer accounts follows a long history in the industry of protecting customer assets and is an important a matter of safety, they are segregated as a fail-safe against a firm going bankrupt. If a company does go under, those funds are supposed to be safely and quickly ensconced to another, theoretically stable, firm. Consider an air traveler who is flying on a plane. Suppose while he’s in flight, the airline declares bankruptcy. His luggage can’t be taken and sold off in order to help the airline pay its creditors; it still belongs to the traveler, even though the airline is technically holding it for him. It’s the same with seg funds. If a firm declares bankruptcy, the seg funds belong to the clients and can’t be used to pay off creditors.
What happened at Sentinel
Sentinel Capital Management was a special kind of FCM, one which invested the seg funds for other futures brokers. They were a kind of money market mutual fund for the futures industry. Beginning in 2003, the principals at Sentinel strayed from their main business and started leveraging a portfolio of structured corporates and CDOs. By 2007 as the CDO market had peaked and was in decline, Sentinel had accumulated over $1.6 billion of these securities. In June 2007, when Sentinel's Repo counterparties started refusing to fund their CDO positions, Sentinel ran out of cash. The securities were returned to Sentinel's clearing account at the Bank of New York and Sentinel borrowed from their customers' seg funds to put up the margin for BONY. The CDO and credit markets continued their decline, and by Aug. 17, 2007, Sentinel ran out of seg fund cash and was forced into default.
The bad news has continued for seg funds since the Sentinel bankruptcy. In 2008, the Bank of New York was sued by the Sentinel trustee, but after an extensive trial, BONY won. It was determined that since Sentinel freely transferred customer assets with minimal BONY supervision, Sentinel had signed a clearing agreement stating BONY had no liability for client seg funds, BONY had performed reasonable due diligence, and no regulator had ever voiced any concern to BONY about Sentinel, then BONY was not liable for Sentinel's abuses. In June 2012, a further ruling stated that once customer funds were transferred out of seg fund accounts and commingled with other monies, those customer funds lost their status as customer property. That was a big ruling and a major setback for seg funds - if customer property was illegally moved out of clients' accounts, the court said it ceased to be client property.
Then, in March 2013, a court ordered FCStone to return $14.5 million that had been distributed to them from Sentinel in August 2007. The ruling was good in one way, the court wanted all client seg funds to be distributed proportionally and FCStone had received more than their fair share. However, the ruling creates uncertainty for seg fund distributions going forward and raises questions as to whether funds will be clawed back by a court years later.
All of these rulings illustrate the major problem with the current seg fund system - that funds are commingled in omnibus clearing accounts. The system does not allow a client to know specifically which securities in the seg fund account belongs to them.
What happened at MF Global
In the case of MF Global, settlement personnel operated under the assumption they could borrow from customer seg funds intraday, as long as the funds went back into the accounts by the end of the day. Since they were able to pay the money back before anybody knew funds were gone, in the end, it was assumed that nobody would get hurt. During the days directly preceding the bankruptcy, there were other expenses that needed to be paid first and the seg funds were suddenly secondary in importance. Employees were being pulled in multiple directions simultaneously, trying to keep the business going, so it’s entirely possible the funds were withdrawn as the result of an honest mistake by a well-meaning staffer. Alternatively, there is the chance an unscrupulous executive took it upon himself to withdraw the funds in direct violation of the law, knowing full well what he was doing. The final verdict on MF Global has yet to be determined.
What is being done to solve this issue: More regulation
What has the futures industry done to correct this problem? Basically nothing. They're leaving it for the regulators to solve, so it shouldn't be a surprise if that the solution is not business friendly.
Right after MF Global went down in December 2011, the CFTC passed some new rules they had wanted to pass for some time, including eliminating "internal repo" within a joint FCM and broker-dealer and increased reporting. In the summer of 2012, the CFTC eliminated the Alternative Method of seg fund calculation, which is too much to explain here but take my word for it as good rule change. Then they added more reporting, allowed regulators access to seg fund statements, and required Seg fund movements over $50 million to require senior executive approval. The CFTC currently has a third wave of new rules in the final stage, now seeking public comment. The new proposed rules would require FCMs to maintain more detailed records, submit more detailed reports and require FCMs to hold a larger amount of their own money in the customer Seg fund accounts.
I really wish these new regulations would solved the seg fund issue and bring back confidence in the industry once and for all, but they won't. Would they have stopped the MF Global violations? No. Sentinel? No. Peregrine Financial Group? No. Filing the same reports more often and creating more reports doesn't necessarily stop someone intent on fraud. Eliminating the Alternative Method was a good new rule, but the proposed capital requirements are going to force more capital requirements on an already marginally profitable industry. With the new capital rules, FCMs are estimated to have to contribute $100 billion into customer accounts, making the futures brokerage business even less profitable. This will ultimately make trading futures more expensive for clients, as FCMs will have no choice and pass on the higher costs. As I said in the beginning, letting regulators solve the seg fund issue would not be business friendly.
Problems with broker-dealer seg funds in the 1980s
Does anyone remember my commentary on April 5, "Five Bankruptcies That Created The Tri-Party Market"? Lombard-Wall, Lion Capital, RTD Securities, E.S.M. Government Securities, and Bevill Bresler & Schulman all collapsed between 1982 and 1985 and their customers suffered serious losses because the firms had under-priced, double-pledged or not pledged securities held in Hold-In-Custody Repo accounts. Sound familiar? That was the last time the securities industry had such a serious problem with seg fund violations and the solution was getting a third party involved - which created the Tri-Party Repo market.
Here's a solution to the current problem
The industry needs to add a third party agent into the seg fund holding process, which would verify and value the securities in the account. The clearing banks don't want additional regulatory responsibility and they certainly don't want to establish millions of Tri-Party-like sub-accounts. But it still can be done. With available technology and already developed systems, securities held in large omnibus seg fund accounts can be allocated to each customer at the futures broker level, using the same methodologies to allocate collateral into Tri-Party accounts.
Here's how it will work:
- The futures broker will keep all the collateral in the omnibus seg fund account at the clearing bank, just like it does now.
- The futures broker allocates the collateral to clients via their trade processing system with minor modifications and the specific securities will appear on the clients' statements. That way, clients know exactly which securities are theirs.
- The clearing bank will then make sure the total seg fund collateral that was allocated to clients matches the total in the clearing account and the securities are priced and margined correctly.
- Like Tri-Party Repo accounts, the broker cannot close its books that night until the clearing bank verifies the collateral is sufficient in the Seg fund accounts.
This simple solution will give futures clients faith in futures industry again because it will allow clients to know the actual securities in their account and know that a third party has priced and verified that it's there.
*Futures Industry Magazine; "How FCMs are adapting to survive in a difficult market"; March 2013
A former salesman, trader, trading desk manager, and global business head in fixed-income, securities finance, and securities clearing and settlement, Scott Skryn recently left Newedge, where he worked for over 12 years. For this and other blogs by Scott Skryn, go to his website. You can reach Scott at firstname.lastname@example.org