Seg funds aren't sexy but...

Taking a page from the securities side

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.

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