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.